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Small Cap Dividends – Can Small Be Beautiful?

In the search for strong, reliable dividends, investors usually turn to the robust yields and comforting track records of the market’s largest companies – but an increasing number are beginning to look further afield for income.

With around seven blue chip stocks accounting for around 50 percent of dividend payouts (and the top 15 payers representing more than 80 percent of dividends), it would be fair to say that small cap stocks are not a familiar hunting ground for income seekers. However, not only is there evidence of increasing interest in small cap dividends from institutional funds, but research suggests that when it comes to total returns, these mythical beasts can outperform the market, too.

Small Cap Divi Stocks Beat the Market, Too

In the US, market-watchers have long promoted the virtues of looking down the value curve for income – although, for accuracy, the definition of ‘small cap’ can vary wildly between the US and Europe (in the US, the small cap range spans $100m - $2.5bn). Nevertheless, research from US fund manager Royce & Associates, claims that small caps are an ideal source of income and a potential key to long-term outperformance. The argument goes that while small caps offer more exciting long-term prospects they are also dogged by downside volatility. The addition of a dividend however, introduces an element of protection and evidence of astute financial management that should act as a buffer against that volatility.

Royce’s research, which stripped down the Russell 2000 index of small-cap shares into dividend payers and non-payers, found that over 19 years to 2011, dividend payers delivered a total return of 10.1 percent while non-payers delivered 6.2 percent (the index itself returned 8.0 percent). In many respects, these finding chime with a general view that dividend stocks can produce superior total returns to non-payers over the long-term.

Dividend Diversification

In the UK there are potentially even more reasons to consider small cap dividend stocks in an investment portfolio – not least because of the thorny topic of diversification.

As already mentioned, a handful of FTSE 100 companies routinely pay the best dividends in the market. If the renowned Dogs of the Dow (and Dividend Dogs of the FTSE 100) strategies focused on dividend payouts rather than dividend yield (which takes share price into consideration) then there would be very little chopping and changing in the portfolio from year-to-year. It is often only when events occur from leftfield that some of these companies lose their positions. In 2010, BP slipped from fifth to seventh best payer following the Gulf of Mexico oil spill, while in 2009 Lloyds lost its seventh place in the wake of the banking crisis (and has yet to restart dividend payments).

Critics claim that the high concentration of companies that make up the bulk of dividend payouts creates particular risks for investors. Not only is a stock-specific event like a Lloyds or a BP damaging to income investors, but a concentration of sectors is also far from ideal. In 2011, the top seven highest dividend payers included Shell and BP, both in oil and gas, and Glaxo and AstraZeneca, both in pharmaceuticals, while in the recent past, financials and consumer goods have also featured heavily.

As a result of this concentration of stocks (and associated risks) at the top of the market, a number of fund managers are looking as far afield as the Alternative Investment Market for diversification opportunities. And why not? Index for index there is actually little to choose between current yields, with the FTSE 100 offering 3.6 percent, the FTSE 250 on 3.7 percent, the FTSE Small Cap on 3.9 percent and the FTSE AIM All-Share on a yield of 4.0 percent.

Professionals Look Elsewhere

In 2011, well known small cap fund manager Gervais Williams of MAM Funds, launched the Acuim UK Multi Cap Income Fund with small cap dividend payers in mind. Williams claimed that, in a subdued post-credit crunch environment, investors would increasingly recognise the powerful compound effect of relatively high and growing dividends on total returns over time. He also used the disastrous events at BP in 2010 as a reason why investors should consider diversifying into ‘good and growing’ small cap dividend stocks. With some 78 percent of AIM stocks not paying dividends, Williams claimed there was scope for those companies to not only start paying good levels of dividend, but also to grow those payouts.

MAM Funds are not the only ones at it; Threadneedle, Mark Slater, Unicorn and Marlborough all run small cap income funds. In a paper earlier this year, Giles Hargreave, co-manager of the Marlborough Multi Cap Income Fund, claimed that small and medium sized businesses are positioned to grow their earnings far more rapidly than the corporate giants of the FTSE 100. “For investors, that is likely to translate into healthy and increasing dividends, as well as the prospect for significantly stronger long-term capital growth than might be expected from the blue chips,” he said.

Small Companies = Big Risks

Despite the bravado, the truth about small cap dividends is that they represent a fraction of the overall income stock universe. Statistics show that in 2011, FTSE 100 stocks were responsible for £59.8bn of dividends, with FTSE 250 companies paying out £6.4 billion and the rest of the market responsible for £1.5bn. Of note, though, in the first quarter of this year FTSE 250 dividends fell for the first time since 2009 while payouts further down the market increased ahead of expectations.

While fund managers appear to like the idea of small cap dividend stocks, the strategy comes with its own risks. Even if companies are increasingly willing to consider making payouts at the same time as maintaining investment, there is evidence to suggest smaller companies are more likely to not pay (or even cut) a dividend – a prospect that larger companies tend to dread. In 2001, Bank of England analysts Andrew Benito and Garry Young produced a paper looking into the factors that can influence a company’s propensity to omit or cut its dividend in a particular year and, in a wider sense, how firms respond to financial pressure. They found that low levels of cash flow, high levels of income gearing and leverage, small scale and greater opportunities for investment were all factors that increased the chances of a company not paying a dividend at all – or making a cut. In other words, faced with tough economic conditions, small cap dividend stocks are more likely to become disappointing investments.

Nevertheless, for those investors that love the idea of mixing capital growth and dividend growth but want the upside excitement that small cap stocks can bring, then a closer look at those companies that are managing to deliver both could be well worth it.